There are several key factors that need to be considered before a company can be invested in, otherwise it’s just speculation. In this post we’ll explore investing using an investment strategy known as value investing. Value Investing simply involves buying and holding under-priced securities usually for the long term.
Using the Value Investing Framework
The first step in evaluating a company to invest in is to choose the what framework you are going to use. I’ll be using Value Investing to help evaluate a company. In step with value investing one such factor worth considering is the margin of safety principal.
What is the Margin of safety principal?
The margin of safety principal states that you reduce the likelihood of risk by purchasing shares at a price that is less than what the company is worth when you add together it’s assets and subtract it’s liabilities. The lower the price below what the company is worth the lower your risk of losing the capital you’ve invested assuming that the company is well run and does not carry too much debt. Investing in this way also gives you greater potential profits.
How does Margin of Safety work?
There are two ways of using the margin of safety principal. The first is to purchase a company after a broad market decline when prices are much lower. The second is to wait for the company to have a problem of some kind that significantly reduces it’s share price. If the company has a problem that has led to a reduction in it’s share price then you must find out how this problem impacts the company. To what degree are future earnings and debt as a percentage of the company effected? Can this problem be fixed or is more of a structural problem that will continue to effect the company?
Look for an economic moat
When evaluating a company it’s important to note whether the company in question has an economic moat. The moat gives a company an advantage over it’s competition where the competitive companies do not have a moat. The wider the moat the more protection the company has against it’s competitors and greater it’s potential profits can be. Economic moats consist of competitive advantages the company creates or obtains. These competitive advantages can consist of things like patents, proprietary technology, and in some cases management.